Gold-Stock Panic Levels

Gold stocks have to be the most despised sector in all the markets. Mainstreamers
barely even know they exist, while even the vast majority of so-called contrarians
scorn them. The sheer contempt for this sector is amazing considering gold
stocks were almost certainly the best-performing sector of the past decade.
This universal antipathy has driven them to panic levels, by far the markets'
best fundamental bargains.

Gold stocks weren't always held in derision. From November 2000 to September
2011, the flagship gold-stock index known by its symbol HUI catapulted an astounding
1664.4% higher! This was over a very long 10.8-year secular-bear span
where the broad stock markets as measured by the mighty S&P 500 fell 14.2%.
After multiplying their investors' wealth by 18x, they should have been the most-popular
sector.

But Wall Street has always hated gold, so there has never been adequate or
fair coverage of the secular gold bull or the resulting secular gold-stock
bull. When gold stocks are strong, they are ignored. CNBC might spend a few
minutes a day on them even if their gains trounce every other sector's. And
when they are weak, they are mocked. What kind of fools would want to grow
their capital 18x in a secular stock bear?

That ride was far from easy, let me tell you. We've been trading great gold
stocks and silver stocks, and recommending them to our subscribers, for this
entire secular gold-stock bull. It's always taken hardened contrarians to weather
this sector's intense volatility. Like everything else, gold stocks don't move
in a straight line. There were plenty of incredibly painful sharp plunges and big corrections
along the way.

The worst by far occurred during 2008's once-in-a-lifetime stock
panic. From March 2008 to October 2008, a very short 7-month span, the HUI
plummeted a catastrophic 70.6%! Holy cow, you should have seen gold-stock investors
then! They were totally convinced the sky was falling, that the secular gold
bull was over, and that gold stocks were going to zero. The wailing and gnashing
of teeth was deafening.

Sounds like today, eh? The recent totally irrational gold
panic fueled by anomalous futures forced selling pummeled the gold stocks
down to prices totally disconnected from fundamental reality. The current
crop of pantywaist gold-stock investors literally panicked, succumbed to
their overwhelming fear rather than transcending emotion to think rationally.
Fear is transient, how did the gold stocks look fundamentally?

Over the long term, all stocks are ultimately valued based on their underlying
earnings streams. Legendary value investor Benjamin Graham, Warren Buffett's
mentor, described this valuation function of the markets as a weighing machine.
All stocks slowly gravitate to a righteous fundamental price based on their
underlying companies' profits. This includes gold stocks, which aren't exempt
from market laws.

But over the short term, the powerful and dangerous emotions of greed and
fear batter stocks all over the place. After long uplegs greed propels stocks
to wildly-overbought levels totally disconnected from their earnings. And after
long corrections fear hammers stocks to radically-oversold levels equally as
absurd. Graham said that the markets act like a voting machine in the
short term, opinion trumps fundamentals.

But emotional extremes never last, they are fickle. Excessive greed or excessive
fear quickly burn themselves out, and stock prices resume their slow fundamental
march to reasonably reflect their underlying profits. Gold stocks are now trapped
in a voting-machine moment where everyone hates them for irrational emotional
reasons, resulting in them weighing far less than their fundamentals demand.

At the S&P 500's last nominal
record high on April 11th, the collective price-to-earnings ratio of
all its component stocks was about 21.2x. General stocks were priced at levels 21
times their underlying annual profits. This is actually overvalued, pricey.
Over centuries all throughout the world, the long-term
fair value of stock markets is 14x earnings. Markets trading above this
are expensive, and below it cheap.

Meanwhile on April 17th with gold-stock investors foolishly choosing to panic,
the collective P/E of the HUI gold-stock index was around 9.3x! Not only is
this the
lowest of gold stocks' entire secular bull by far, it is very cheap in
absolute terms. A dollar of earnings in gold stocks could be purchased for
just $9 in stock price, compared to $21 for general stocks. Gold stocks were 56%
cheaper than the rest of the markets!

Now in most sectors (not necessarily individual stocks), value investors
would flood in to buy companies at 9x earnings. It is a guaranteed win over
the longer term as the weighing function of the stock markets overcomes the
temporary swings in sentiment. And 9x for gold stocks is far cheaper for this
sector than it would be for general stocks. Gold stocks usually trade at a
premium due to their very outsized returns.

Between 2007 and 2012, the HUI's P/E ratio averaged 27.9x earnings. This long
6-year span included both major uplegs and major corrections, even 2008's insane
stock panic. So by their own recent standards, the loathed gold stocks are
now trading at steep discounts of 2/3rds to their normal valuations!
The magnitude of this total fundamental disconnect is mind-boggling, it makes
no sense whatsoever.

Was Graham wrong? Do earnings no longer matter? Are gold stocks going to be
perpetually hated and therefore never reflect their underlying profitability?
Of course not. The extreme fear holding down gold stocks can't and won't last.
The markets have always abhorred sentiment extremes, they are very temporary.
And once they inevitably pass, misvalued sectors spring back to normal relatively
rapidly.

This certainly happened in gold stocks after that once-in-a-lifetime 2008
stock panic. After plummeting 70.6% and stoking epic levels of gold-stock fear
that dwarfed today's, in just 13 months the HUI had fully bounced back. The
weak-willed investors who succumbed to their own fears sold near the bottom to
set their terrible losses in stone. But the strong contrarians held on to enjoy
the massive 236.9% recovery.

By September 2011, the gold stocks as measured by the HUI had more than
quadrupled since the panic lows with a staggering 319.0% gain over 2.9
years. Why? This sector had been wildly mispriced when the vast majority
of investors chose to vote against it when they were blinded by their own
fear. But that fear quickly dissipated and the weighing-machine function
of stock markets gradually normalized prices.

This background is very important now because gold stocks are actually at
more-extreme lows today than they were during 2008's stock panic! And if they
quadrupled after that panic anomaly, they are highly likely to at least
quadruple from their recent panic lows in the coming years. This is measured
by the all-important HUI/Gold Ratio. The HGR is a simple construct that divides
the HUI's close by gold's own.

Obviously gold miners mine gold. Their profits as a sector balloon
when gold rises and contract when gold falls. So the price of gold is the overwhelming
primary driver of gold miners' long-term profitability,
which ultimately determines their stock prices. Thus the HUI/Gold Ratio has
been one of the best tools to measure how gold stocks are faring fundamentally
throughout their entire decade-long secular bull.

This chart, long one of my favorites, superimposes the HGR in blue over the
HUI itself in red. By this key valuation metric, gold stocks were just driven
to levels relative to gold well under even the crazy 2008 stock-panic
levels! This is the biggest valuation anomaly ever seen in this gold-stock
bull by far, showing how excessive fear has been. The market voting machine
temporarily forced gold stocks to ludicrous lows.

In October 2008 in the dark heart of the stock panic when it really looked
like the world was ending, the HGR slumped to 0.207x on mind-boggling fear.
That turned out to be a 7.5-year low for the HGR, since April 2001 which happened
to be the very month the past decade's powerful secular gold bull was born.
Without context that HGR extreme is meaningless, so this chart really puts
it in proper perspective.

For 5 full years before that ultra-rare fear superspike, the HGR traded
in a tight secular range between 0.46x and 0.56x. Gold stocks became more valuable
relative to gold when investors got greedy and loved them, and less valuable
when they got scared. But the HGR didn't spend too much time far away from
its secular average of 0.511x. The HUI gold-stock index generally traded at half the
prevailing gold-price levels.

But the first true stock panic in 101 years shattered this longstanding fundamental relationship
between the gold miners' stocks and the driver of their profits. As gold-stock
investors fled in terror, gold stocks were driven down far faster than the
also-weak gold price. So the HGR plummeted, shattering support and falling
to levels previously unthinkable. It was very obvious at
the time that this anomaly wasn't sustainable.

And indeed the crazy-oversold gold stocks bounced back sharply, rallying far
faster than gold. At 0.437x in late 2009, the HGR had made up so much lost
ground that it was on the verge of breaking back into its pre-panic trading
range. But even though gold stocks kept powering higher dramatically after
that, gold climbed so fast in the Fed's inflationary quantitative-easing
era that it kept pace with the HUI's big gains.

So the HGR stalled, starting to drift sideways between 0.35x and 0.40x or
so. But this new post-panic norm started to break down in the summer of 2011.
That was when the anxiety about Washington technically defaulting on Treasuries
surrounding the last debt-ceiling debate ignited a rare sharp
summer rally in gold. Gold stocks weren't as attractive as gold in such
a scary scenario, so the HUI lagged the metal.

And gold-stock psychology, which had never quite fully recovered from the
deep scarring of 2008's stock panic, started deteriorating rapidly as both
gold and gold stocks corrected after gold reached very
overbought extremes in August 2011. Since gold stocks nearly always fall
faster than gold in a correction due to their profits leverage to the metal,
the HGR kept sliding lower and losing even more ground.

This long downtrend finally started reversing late last summer when gold and
its miners' stocks surged after gold sentiment hit unsustainably-bearish
extremes. I explained the gold action since in much depth in a February
essay on gold's
capitulation and last week's essay on gold's wild
panic selling. As gold continued to be sold off, the already-oversold gold
stocks started collapsing. This dragged the HGR lower still.

Just last week, this key gold-stock valuation metric was pummeled to 0.187x.
This was a 12.0-year low well below even the level seen in 2008's stock panic!
So relative to gold, gold stocks were just driven to sub-panic levels.
That extreme anomaly couldn't persist in the stock panic and it can't persist
today. Gold stocks have never been so hated in their entire secular bull, meaning
fear has to have finally peaked.

Seeing a sector that usually trades at 27.9x earnings languish at just 9.3x,
a 2/3rds discount, certainly illustrates the fundamental absurdity of today's
gold-stock prices to those familiar with valuations. But I wonder if that can
resonate well enough with less-studied investors. So let's look at the HUI's
ludicrous disconnect from fundamental reality another way, from previous HUI
milestones at the same level.

At April 17th's closing low of 257, the HUI was at its worst levels seen in
4.3 years. That very day, gold and silver were trading at $1374 and $23.25.
But the last time the HUI was under 257 in January 2009, gold and silver were
41% and 55% lower at $810 and $10.50! And lest you think gold miners were more
profitable back then, they weren't. The HUI's P/E then was 23.6x, far higher
than last week's 9.3x.

The very first time the HUI challenged 257 in this secular bull was way back
in December 2003. Back then gold and silver were 70% and 76% lower at $405
and $5.50! Seeing gold stocks trading at the very same levels today with
gold and silver 240% and 327% higher defies all logic. This disconnect between
gold stocks and their underlying fundamentals couldn't be more extreme, it
is ludicrously absurd.

Per the HUI/Gold Ratio, gold stocks have been falling out of favor since either
early 2006 or early 2011 depending on how far back you want to take the trend.
Does any market run in one direction forever? Will gold stocks be hammered
down to 7x or 5x or 3x earnings? The chance of that within a fundamentally-driven secular
gold bull is likely zero. The extreme antipathy to this sector will have to
abate.

This one-way trade of irrationally hating gold stocks and ignoring their
fundamentals has created a thriving cottage industry of analysts and
traders trying to rationalize all this as normal. There are several
major theses and countless sub-theories trying to justify gold stocks trading
as if their earnings will never matter again. Traders as a group wax the
most bearish at the worst-possible times, right at major bottomings.

Earnings are the only thing that matter for long-term stock prices, period.
No sector is exempt from ultimately being weighed and fairly valued. And as
long as the secular gold bull isn't over, which it can't be without a proper popular-mania
climax, gold miners will remain very profitable. Sooner or later their
incredibly low valuations will matter, value investors will move capital into
the cheapest sector in the stock markets.

I am probably the last one on the planet, but as a rational contrarian I still
expect gold stocks to regain their pre-panic average HGR of 0.511x. Before
you laugh, realize not too long ago silver was in a similar situation where
everyone thought it was hopeless for it to regain its pre-panic average relative
to gold. But silver not only surged to hit those levels once again as it returned
to favor, it far
exceeded them to the upside.

The markets are tyrannically cyclical, every sector out of favor eventually
returns to favor again and vice versa. That law of sentiment is as immutable
as stock prices ultimately reflecting underlying corporate earnings. Based
on today's still-battered gold prices, a 0.511x HGR would put the HUI at 731.
This is 157% higher than it was in the middle of this week even after recovering
3/7ths of its gold-panic losses!

And even if you believe the bears' endless rationalizations about why gold
stocks are doomed, consider the post-panic average HGR which includes the extremely
low levels of 2013. That is 0.338x. Even if gold stocks will somehow never
again be as popular as they were pre-panic, when everyone but hardcore contrarians
ignored them just like today, that HGR with today's gold levels puts the HUI
at 484.

Which is still 70% higher than this week's horrendous gold-stock levels! With
the general stock markets very overbought, hyper-complacent,
and at nominal
record highsin a secular bear, can you think of any other sector
with a high probability of climbing 70% just to return to merely average? I
sure can't. Gold stocks can't keep falling deeper out of favor forever, there
is no one left who doesn't already hate them!

So if you're a contrarian, if you really walk the walk and buy low, gold stocks
are by far the most attractive sector in the stock markets today. Yes it's
been a tough 2013, but so what? The lower this sector is pummeled the cheaper
it gets, and the bigger and faster the subsequent mighty upleg will be as sentiment
inevitably turns. Buying low and holding as prices are driven lower is irrelevant
if they are due to at least quadruple.

At Zeal it feels like we're the only ones left bullish on gold stocks. We
keep diligently studying them and buying them cheap. We've spent many years
researching most of them (many hundreds) to pick our fundamental favorites.
They are covered in depth in our popular and fascinating fundamental
reports. There are no better profiles of high-potential gold and silver
stocks anywhere, so buy some
reports today and get deployed!

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The bottom line is gold stocks have been driven down to panic levels by the
recent gold-futures forced selling. They have never been cheaper relative to
gold in their entire secular bull. They have never traded at lower traditional
valuations based on their underlying earnings. And they have never been cheaper
compared to their average valuations of recent years or the general stock markets'
prevailing valuations.

So naturally everyone loathes gold stocks. I've never seen them so universally
hated and deeply out of favor. But this is a sentiment anomaly that won't last.
Eventually all stocks are weighed by the stock markets and priced to fairly
reflect their underlying earnings streams. Gold stocks are no exception. Their
pricing anomaly is so extreme today that it will take a gigantic upleg to mean
revert to normal levels.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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